Tuesday, March 29, 2016

Are Trade Deficits Dangerous?

There are several inconsistencies--or really a "bait and switch" rhetoric.

It starts with the claim that countries with trade surpluses are stealing away labor demand from countries with trade deficits.

This is not true and it is based on simplistic Keynesian thinking. What the trade surplus countries are doing is providing additional saving which allows for additional investment--spending on capital goods. There is no particular reason to suppose that increased demand for capital goods--machines, equipment, and buildings, is any less labor intensive than the production of import competing or export goods.

It may in fact be that growing trade has reduced the demand for some types of labor It is even possible that it could reduce the demand for labor in general. But that has nothing to do with trade deficits. That is, even if the U.S. ran a trade surplus, the same effect could occur. For example, suppose the U.S. imports furniture and t-shirts and exports wheat and corn. It runs a trade surplus with the difference used by U.S. investors to build foreign factories (so they can better produce the furniture and T-shirts.) Farmers in Kansas and South Dakota earn higher incomes. Factory workers in small towns in North and South Carolina earn less. They have to find new work--maybe moving to Kansas and providing services to the farmers. Retired farmer Jones who rents some of his land to Farmer Smith enjoys some of the greater prosperity. It is certainly possible that the effect is an increase in share of income going to the owners of farm land (most of whom are farmers) and less going to labor. And if those ex-factory workers stick around in their hometowns in Appalachia, it is very likely that the effect will be lower incomes for them.

However, it is also possible for the opposite to occur. For example, the U.S. could sell lumber to Japan and import cars. Suppose the U.S. runs a trade deficit because Japanese investors are buying newly-constructed buildings in the U.S. It is certainly possible that the construction of buildings and production of lumber is more labor intensive than the production of cars.

More importantly, a trade deficit and associated net capital inflow makes it less likely that trade would result in a reduction in the share of income going to labor. The added capital investment, by providing additional supplies of a complementary factor, should raise labor demand.

The argument that trade between developing and modern economies results in a reduction in labor demand involves economizing on capital goods. According to the argument, the modern economy has lots of capital--plenty of sophisticated machinery--that is absent from the developing economy. By shifting production of goods that require less capital to the developing economy and production that requires more capital to the modern economy, the result is an increase in total production and an increase in the value of capital in the modern economy. While the demand for labor in the modern economy could either increase or decrease, the labor share decreases--"labor" gets a smaller share of a bigger pie. The bigger share of a bigger pie going to capital is clearly an improvement. A smaller share of a larger pie going to labor could go either way. If the well being of workers is your concern, what happens is of key importance. (For a Marxist, the distribution of income between capital and labor is all that matters, so even if a smaller share of a bigger pie is more--who cares, there is more exploitation.)

Trade, in this way, provides a substitute for shifting capital from the modern economy to the developing economy. If capital is actually moving the opposite direction, as happens with a trade deficit, that will tend to offset this process.

So, if the concern is that trade with Mexico or China is adversely impacting the demand for labor relative to capital, then a trade deficit and net capital inflow should be celebrated! On the other hand, one would expect that if differential capital to labor ratios are really very important in the development process, the advanced economies not only should be exporting relatively capital intensive products to the developing world, they should also be running trade surpluses and their savings should be shifted to profitable capital investment in developing countries.

I don't want to entirely dismiss these processes regarding the optimal allocation of capital and how it impacts labor and capital, but I do think it all comes from a long tradition of focusing on a growing capital stock as the key source of economic growth. In my view, the key source of economic growth is instead improvement in technology. The ability of developing countries to change their production processes to reflect improved technology allows them to produce more output and earn more income. The capital they have becomes substantially more productive.

After asserting that countries with trade surpluses compel other countries to consume more, the author takes that back--recognizing what is correct. Countries with trade surpluses invest less than they save and countries with trade deficits invest more than they save. The problem here, I think, is a mixture between old Keynesian thinking that investment is fixed and new Keynesian models that have no investment.

In the "workhorse" new Keynesian model, there is no investment at all. Interest rates play a key role, however, and can only relate to consumer loans. A saver/lender consumes less than income and a dissaver/borrower consumes more than income. Of course, with their representative agent models, no one ends up saving or lending at all. Everyone just consumes what they earn. Still, it appears that the go to assumption about trade deficits is that they represent dissaving--consuming more than income. Well, they can, but they don't have to.

Anyway, after making this false statement about trade deficits requiring dissaving, it is immediately reversed, noting as an aside that yes, a net capital inflow can be used for capital investment. And then we get a list of bad investments that have occurred. What evidence is there that it was the net capital inflow that funded the "bad investments?" Of course, in hindsight, bad investments are a waste! The market system punishes investors who make bad investments with losses.

Then we get a version of the "global savings glut" story. The notion is that interest rates have been low worldwide because there is a "global savings glut." The countries with trade surpluses--which are saving more than they invest--are exacerbating this problem. It is really back to crude Keynesianism. The paradox of thrift purportedly shows that saving is bad and results in poverty. Well, it isn't that bad, because here we have the recognition that added saving results in lower interest rates and more investment.

But the investment due to the lower interest rates are supposedly these wasteful and bad investments--bubbles. But in reality, bubbles are alternatives to low interest rates. It is rational to take more risk when safe interest rates are lower. If you can earn a higher yield, it is sensible to take part of the benefit in terms of greater safety. Turn that around and the result is lower yields makes taking higher risks reasonable.

But that doesn't make bubbles rational. To motivate more sound investment, lower interest rates are necessary. If there is a bubble, the demand for investment is irrationally high, allowing for more investment at higher interest rates. With no bubbles, interest rates must be lower to generate the appropriate amount of sensible investment.

Further, the interest rates that most businesses have to pay to fund capital investment are not "crazy low." The only interest rates that are "crazy low" are short term U.S. government guaranteed instruments.

The U.S. has had massive budget deficits, which is a reduction in U.S. saving. That we run trade deficits and obtain a net capital inflow means that these deficits have a smaller negative impact on U.S. capital investment than otherwise. If the U.S. started to run modest budget surpluses and so gradually pays off the U.S. national debt, would the U.S. still have a trade deficit? Perhaps. If so, let us hear complaints about other countries saving too much then.

Finally, all that said, it is bad for foreign countries to manipulate their economies to accumulate large official foreign exchange reserves. But it is mostly bad for their people.

When "foreign exchange" was gold bullion, then when any one country accumulated more, other countries would have less. Aside from devaluation, equilibrium required a deflation of prices and incomes. Usually, such deflation was very painful with reduced output and employment. If unexpected, there was a transfer from borrowers to lenders as well--a transfer that did not reflect the agreed sharing of risk of particular production processes.

In the twentieth century, there were efforts to have countries work together to avoid this sort of problem. However, the end of the gold standard has solved these problems. These traditional concerns about "trade surplus" countries just don't apply. It is an artifact of a bad monetary order.

And that brings us to today. In the late 20th century, the Fed doubled-down on its traditional fixation on interest rate targeting--focusing on short and safe rates. It adopted inflation targeting. The interest rate target results in problems when short and safe interest rates are very low. But that is a self-inflicted wound. Further, inflation targeting has generated slow recoveries ever since it was adopted. These slow recoveries appear to create problems with short and safe interest rates, but the real problem has been the populist backlash due to years of weak labor markets. Just now, the foreigners are taking all the jobs, or maybe it is the robots. Sure.....that's the problem. It happens with every recession and with a weak recovery, it just lasts longer.